"Melt-up" was a popular phrase among year-end commentators looking at 2018 stockmarket prospects.
This should not be surprising: meltdown is often the equally emotional response to irrational enthusiasm for stockmarket investment, which may well happen this year or next on the back of the second-longest bull market in US history.
As commentator John Authers wrote in the Financial Times: “Unless the economic data cruelly misleads us, the world economy has reached a point where it can grow in a strong and co-ordinated way. The data admits little other interpretation (even if US job growth is slowing as full employment nears). The world has not looked so well poised for growth in at least a decade.
“And the desperate monetary policy measures that central bankers used to stave off a second great depression look as though they might allow the world economy to take off again without having to endure a crash or a bout of hyperinflation first.”
Avoiding unnecessary risks
Knowing that asset prices are high, and are going higher yet in a ‘melt-up’, is one thing. But avoiding the meltdown is key for investors concerned with the long-term growth of their savings. If a market slump turns 100 into 50, that 50 has to double in value to get back to its starting level, which may prove a whole lot harder.
There have been significant melt-ups and meltdowns over the past 20 years, and January’s column examined the performance of 10 ‘dividend hero’ investment trusts over this period. All avoided the traps, producing not only a dividend income nearly comparable with the capital invested, but also trebling or quadrupling that initial investment. This is what positive compounded returns do for investors.
Table 1 shows those same investment trusts, this time alongside their initial dividend yields, and their actual annualised returns 20 years later. Scottish Mortgage, with its emphasis on technology, and F&C Global Smaller Companies are the two outstanding winners over this period, but all did well.
Even Alliance Trust, burdened for most of the period with high board costs only suitable for a large and successful financial services company, produced results that most unit trusts can only envy.
Keeping investment simple
Therein lies a lesson for all investors. These investment vehicles, incorporated under company law that enables them to keep back profits against future ‘rainy days’, have remained true to their Victorian founding precepts. These are to identify firms with strong cashflows, supported by solid business prospects, willing and capable of paying a rising dividend, and then to diversify internationally to avoid the risks inherent in any one economy or region. In other words, invest for annual income and not capital growth.
These principles built, over 150 years, the enviable success of Genevan private banks and their British equivalents, the partnership stockbrokers. But then came the computer, and shortly afterwards the university professor. These quickly showed that markets were efficient, and that no one could beat them.
But that did not matter if economies were growing, since asset prices follow economic growth, albeit with a time lag. This was certainly enough of an argument to persuade hard-headed chief executives to allow their new (and legally required) staff pension funds to be invested in the stockmarket.
Excitement of the future
Suddenly, investment management was not only about the rich, but also the powerful. Asset management became big business – larger and more profitable than banking itself – and many of the simple lessons of the past were forgotten.
One of these was cost: stockmarket returns are low – indeed minute compared with retailing or manufacturing – and high costs, whether fees or dealing, can destroy them utterly.
That did not matter in the early days. Millions were flooding into investment management coffers, the world was recovering from the second world war, globalisation was rebuilding trade to levels not seen since the beginning of the first world war, and stockmarket investment was profitable, both to pension fund beneficiaries and to the middle classes investing in the new unit trusts.
Inflation was a real danger, and a trigger for equity investment. The efficient market hypothesis (EMH) argued in favour of dealing. If no analyst could beat the market, concentrate on the market itself. Price information showed that security prices moved between 30 and 50 per cent a year, so in theory active dealing should capture much of that change.
Sadly, the timing never seemed to work. The reason may be that, as behavioural economists are starting to show, few of us are the emotionless, entirely rational actors that economic theory demands. Or it may be that EMH is right but in an unexpected way – that markets react to our dealing behaviour and not to information about companies. Whatever the reason, this method of investment was costly and a failure.
Clever theories
But EMH also offered other possibilities. Dealing did not work in the context of the overall market, but choosing the right asset allocation might. Defensive and aggressive have always been widely seen as fashionable alternative styles of investment, as were value and growth.
International diversification then offered even greater choice: emerging versus mature, and maybe in future declining or dying for some industries or regions.
But still investors remained dissatisfied with performance, or at least the cost-return ratio.
Now it is smart beta, which, as the FT Lexicon puts it, “is a rather elusive term in modern finance. It lacks a strict definition and is also sometimes known as advanced beta, alternative beta or strategy indices. It can be understood as an umbrella term for rules-based investment strategies that do not use the conventional market cap weights that have been criticised for delivering sub-optimal returns by overweighting overvalued stocks and, conversely, underweighting undervalued ones”.
It continues: “Smart beta strategies attempt to deliver a better risk-and-return trade-off than conventional market-cap-weighted indices by using alternative weighting schemes based on measures such as volatility or dividends.
“Smart beta refers to an investment style where the manager passively follows an index designed to take advantage of perceived systematic biases or inefficiencies in the market. It therefore costs less than active management, since there is less day-to-day decision making for the manager, but since it will, at the very least, have higher trading costs than traditional passive management (which minimises those costs), it is a pricier option.”
Trust the experts
Pity the poor manager condemned to making investment sense of that! So much simpler to concentrate on finding companies that make money, and do pay dividends. Table 1 indicates that playing asset-allocation games has no part in investment trust management. Concentrate instead on those managers who know what they are doing, and have been here before.
Mr Authers finishes his outlook for 2018 with a warning: “Asset prices do not overlap with the economy, at least in the short run. So I want to ask this question: ‘After almost a decade in which a tripling of the US stockmarket has failed to generate any excitement or even any great feeling of wellbeing, are we at last reaching a point of euphoria?’
“I suspect the answer is ‘yes’. And in the counter-intuitive world of financial markets, that might be bad news. It will certainly be challenging to navigate.”
